When it comes to fighting inflation with TIPS, it helps to know all the tools you have at your disposal.
This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Rusty Vanneman, chief investment officer of Omaha, Neb.-based CLS Investments and is co-authored by Josh Jenkins, CLS Investment research analyst.
Despite the daily chatter regarding the Federal Reserve and what it might do and when, there are many ways investors can actively manage their bond portfolios above and beyond attempts to time the Fed’s actions.
One such opportunity involves taking advantage of the inherent seasonality of inflation expectations to rotate between nominal Treasurys and Treasury inflation-protected securities (TIPS).
And there are plenty of options, from one of the oldest and biggest TIPS in the space, the iShares TIPS Bond ETF (TIP | A-99) or more newfangled approaches to tackling inflation through TIPS, such as the use of an internationally focused fund like the PIMCO Global Advantage Inflation-Linked Bond Exchange-Traded ETF (ILB | C).
But first, let’s look more closely at TIPS and how they work.
Very Brief History Of TIPS
TIPS are increasingly becoming the “risk-free asset” of choice among many asset allocators, as they become a key part of many strategic allocations. TIPS were first issued by the U.S. Treasury in 1997, and by the early 2000s, more than $200 billion worth of the securities had entered the market.
Like Treasurys, TIPS pay a fixed rate on the bond’s principal value. Unlike nominal Treasurys, however, the principal amount is adjusted by inflation, as measured by the nonseasonally adjusted Consumer Price Index for all Urban Consumers. This means that TIPS deal in a “real” (i.e., inflation-adjusted) fixed-rate framework, while nominal Treasurys do not, leaving the latter vulnerable to inflation.
Breakeven Inflation Rate
How can investors decide to alter their holdings in TIPS and nominal Treasurys? One way is to calculate the rate of inflation where an investor holding TIPS would break even with an investor holding Treasurys. This can be approximated by:
Breakeven inflation rate = (1 + Treasury nominal yield) / (1 + TIPS real yield) -1
When evaluating which exposure to take, you can simply compare your inflation expectations versus the market’s by using the breakeven inflation rate as a proxy for the market’s expectation. For example, if the breakeven was at 2.0 percent, and you expected inflation to be higher, you would purchase the TIPS. If you expected inflation to be lower than 2.0 percent, you would want the nominal Treasury.
Seasonality In Breakevens
There is some seasonality within the breakeven inflation rate, because the inflation measure used in TIPS is not seasonally adjusted. An important consequence of this is that breakeven inflation rates have a tendency to “peak and trough” around the same time each year.
To identify a potential rotation signal, we evaluated a simple trigger that would signal when it would be appropriate to rotate between the two assets based on the level of the breakeven rate. We collected the closing level of the 10-year breakeven rate for each day going back five years. The chart below illustrates the breakeven rate over time, as well as the average level.
For any day that the current breakeven rate was more than one standard deviation above or below the average, we calculated the return variance between intermediate- to long-dated Treasurys and TIPS three months later.
For observations where the breakeven rate was at least 1 standard deviation below the average, TIPS outperformed Treasurys by more than 1 percentage point over the next three months, with the TIPS outperforming more than 80 percent of the time.
Similarly, when the current breakeven rate was more than 1 standard deviation above the average, Treasurys outperformed TIPS by slightly more than 1.0 percent, over the next three months, with Treasurys outperforming just under 80 percent of the time.
The results of the analysis were encouraging, so the methodology was used to evaluate the two-year and five-year breakeven inflation rates as well. Across each of the time frames, the results were consistent.
Rotating between TIPS and Treasurys, using the level of the breakeven inflation rate as a trigger appears to be a viable strategy. As it happens, the breakeven rates for each of these time frames are hovering just above 1 standard deviation below the average, signaling it may soon be time to begin a back-rotation into TIPS.
Inflation-Linked Bond ETFs
There are many fine inflation-linked bond ETFs. Let’s review three different kinds that we find interesting.
- First, there are the longer-duration TIPs ETFs, such as the iShares TIPS Bond ETF (TIP | A-99) or the Schwab U.S. TIPS ETF (SCHP | A-99). Both of these ETFs are low-cost and provide dependable longer-duration, high-quality inflation-protected fixed-income exposure. “TIP” is the giant in this inflation-protected fixed-income space and trades well, but SCHP’s expense ratio is even lower. Given their characteristics, both work well for core strategic allocations.
- Many investors, including ourselves at CLS, also like shorter-duration inflation-linked ETFs, both for strategic reasons (ability to hedge inflation) and tactical reasons (given the low level of interest rates). The PIMCO 1-5 Year US TIPS Index ETF (STPZ | A-74), the FlexShares iBoxx 3-Year Target Duration TIPS ETF (TDTT | A-46) and the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP | A-98) are all fine ETFs.
- The last grouping that intrigues us is the international inflation-linked fixed-income ETFs. Given the U.S. dollar’s run of late, the buck now looks overbought and overvalued. For those investors looking for international fixed-income exposure, the SPDR DB International Government Inflation-Protected Bond ETF (WIP | B) and the PIMCO Global Advantage Inflation-Linked Bond Exchange-Traded ETF (ILB | C) are interesting. The latter is doubly interesting, as it is an actively managed fixed-income ETF, something that PIMCO has been able to do successfully with a few other fixed-income ETFs.
The takeaway is this: There are plenty of choices in the TIPS ETF market, and it’s wise to keep up on them, as sooner or later, inflationary pressure is likely to start climbing.
CLS Investments is an Omaha, Neb.-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Chief Investment Strategist Scott Kubie at 402-896-7406 or at Scottk@clsinvest.com. Please click here for a complete list of relevant disclosures and definitions.